The Macroeconomics of Open Economies: Basic … · The Macroeconomics of Open Economies: Basic Concepts (Chapter 31 in Mankiw and Taylor)

The Macroeconomics of Open Economies:

Basic Concepts

(Chapter 31 in Mankiw and Taylor)

Basic Concepts

• Closed economy

– Economy that does not interact with other

economies in the world (RoW)

• Open economy

– Economy that interacts freely with other

economies around the world

• International trade can make everyone better

off, since it lets them specialise in producing

those goods and services in which it has a

comparative advantage

2

International Flow of Goods

• An open economy interacts with the RoW by buying

and selling both goods/services and capital assets

(stocks and bonds etc.)

• Exports

– Goods & services

– Produced domestically

– Sold abroad

• Imports

– Goods and services

– Produced abroad

– Sold domestically 3


• Net exports

– Value of a nation’s exports minus the value

of its imports

– Also called the trade balance

• Trade surplus

– Excess of exports over imports

• Trade deficit

– Excess of imports over exports

• Balanced trade

– Exports equal imports

4


• Factors that influence a country’s exports,

imports and net exports:

– Tastes of consumers for domestic & foreign goods

– Prices of goods at home and abroad

– Exchange rates

• People use domestic currency to buy foreign currencies

– Incomes of consumers at home and abroad

– Cost of transporting goods from country to country

– Government policies toward international trade

5

The increasing openness of the U.S. economy

• Increasing importance of international

trade and finance

– 1950s, imports and exports: 4-5% of GDP

– Recent years:

• Exports – increased more than twice

• Imports – increased more than three times

• Similar story for UK and indeed the world

economy

6

The increasing openness of the U.S. economy

• Increase in international trade

– Improvements in transportation

• Bigger and faster ships; planes; better

storage

– Advances in telecommunications

– Technological progress

– Government’s trade policies

• NAFTA

• GATT

7

Figure 1

8

The internationalisation of the U.S. Economy

This figure shows exports and imports of the U.S. economy as a percentage of U.S. gross

domestic product since 1950. The substantial increases over time show the increasing

importance of international trade and finance.

International Flow of Capital

• Net capital outflow

– Purchase of foreign assets by domestic

residents minus the purchase of domestic

assets by foreigners

– Flow of capital takes two forms:

• Foreign direct investment

– You buy a BMW car factory

• Foreign portfolio investment

– You buy shares in BMW

9

International Flow of Capital

• Factors that influence net capital outflow:

– Real interest rates paid on foreign assets

– Real interest rates paid on domestic

assets

– Perceived economic and political risks of

holding assets abroad

– Government policies that affect foreign

ownership of domestic assets

10

Net Exports=Net Capital Outflow

• Net exports (NX) or trade balance

– Imbalance between a country’s exports

and its imports of goods and services

• Net capital outflow (NCO)

– Imbalance between

• Amount of foreign assets bought by domestic

residents

• And the amount of domestic assets bought

by foreigners

• Identity: NCO = NX 11


• When NX > 0 (trade surplus)

– Selling more goods and services to

foreigners than it is buying from them

– From net sale of goods and services

• Receives foreign currency

• Buy foreign assets

• Capital - flowing out of the country: NCO > 0

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• When NX < 0 (trade deficit)

– Buying more goods and services from

foreigners

• Than it is selling to them

– The net purchase of goods and services

• Needs financing

• Selling assets abroad

• Capital - flowing into the country: NCO < 0



Saving and investment

• A nation’s saving and investment are

fundamental to its long run economic

growth

• So let’s see how these variables are

related to the international flow of goods

and capital, as measured by net exports

and net capital outflow

14

Some simple algebra

• Open economy: Y = C + I + G + NX

• National saving: S = Y – C – G

• Y – C – G = I + NX

• S = I + NX

• NX = NCO

• S = I + NCO

• National saving = Domestic investment +

Net capital outflow

• i.e. when the UK saves a £ it can be used to

accumulate capital at home or abroad 15

International Flows

• Trade surplus: Exports > Imports

• Net exports > 0

• Y > Domestic spending (C+I+G)

• S > I

• NCO > 0



International Flows

• Trade deficit: Exports < Imports

• Net exports < 0

• Y < Domestic spending (C+I+G)

• S < I

• NCO < 0



International Flows

• Balanced trade : Exports = Imports

• Net exports = 0

• Y = Domestic spending (C+I+G)

• S = I

• NCO = 0



Table 1

19

International Flows of Goods and Capital: Summary

This table shows the three possible outcomes for an open economy

Is the U.S. trade deficit a national problem?

• In the past two decades the U.S.

– Borrowed heavily in world financial

markets

– To finance large trade deficits

• Before 1980

– National saving & domestic investment

were close

– Small net capital outflow

20


• After 1980

– National saving - fell substantially below

investment

– Net capital outflow - a large negative

number; i.e. a capital inflow

– U.S. - going into (external) debt

21

Figure 2: Recall, S-I=NX so I>S implies a trade deficit

22

National Saving, Domestic Investment, and Net Capital Outflow

Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see

from the figure that national saving has been lower since 1980 than it was before 1980. This fall in

national saving has been reflected primarily in reduced net capital outflow rather than in reduced

domestic investment.

Figure 3: S = I + NCO, so I>S implies NCO<0

23

National Saving, Domestic Investment, and Net Capital Outflow

Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that

national saving has been lower since 1980 than it was before 1980. This fall in national saving

has been reflected primarily in reduced net capital outflow (i.e. capital inflow) rather than in

reduced domestic investment.


• Trade deficit induced by a fall in saving

– The nation is putting away less of its

income to provide for its future

– No reason to deplore the resulting trade

deficits?

• Better to have foreigners invest in the U.S.

economy than no one at all

24


• Trade deficit induced by an investment

boom

– Economy is borrowing from abroad to

finance the purchase of new capital

goods

• For a good return on investment - the

economy should be able to handle the debts

that are being accumulated

• For a lower return on investment - debts will

look less desirable

25

Nominal Exchange Rates

• Nominal exchange rate

– Rate at which a person can trade currency of

one country for currency of another

• Appreciation (strengthen)

– Increase in the value of a currency

– As measured by the amount of foreign currency

one unit of the domestic currency can buy

• An appreciation means one can buy more foreign

currency

• N.B. can always express the exchange rate the other way

round – i.e. as the domestic price of foreign exchange 26

Nominal Exchange Rates

• Depreciation (weaken)

– Decrease in the value of a currency

– As measured by the amount of foreign

currency it can buy

• A depreciation means one can buy less

foreign currency



Real Exchange Rates

• Real exchange rate

– This is the price at which a person can

trade goods and services of one country,

for goods and services of another:

28

Real exchange rate

Nominal exchange rate Domestic price

Foreign price

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Real Exchange Rates

• Real exchange rate = (e × P) / P*

• Using price indexes

• e – nominal exchange rate between the

U.K. pound and foreign currencies

• P – price index for U.K. basket

• P* – price index for foreign basket



Real Exchange Rates

• Depreciation (fall) in the U.K. real

exchange rate

– U.K. goods - cheaper relative to foreign

goods

– Consumers at home and abroad - buy

more U.K. goods and fewer goods from

other countries

• Higher exports

• Lower imports

• Higher net exports



Real Exchange Rates

• An appreciation (rise) in the U.K. real

exchange rate

– U.K. goods - more expensive compared to

foreign goods

– Consumers at home and abroad - buy

fewer U.K. goods and more goods from

other countries

• Lower exports

• Higher imports

• Lower net exports



Nominal exchange rates vary over time -

Dollar price of £1

32

• Why do nominal exchange rates vary as

much as they apparently do?

33

Purchasing Power Parity

• Purchasing power parity, PPP

– First (long run) theory of exchange rates

– A unit of any given currency

• Should be able to buy the same quantity of

goods in all countries

• Basic logic of purchasing power parity

– Based on the Law Of One Price (LOOP)

– A good must sell for the same price in all

locations



Purchasing Power Parity

• This is due to arbitrage

– Take advantage of price differences for

the same item in different markets

• And trade until there is

– Equality or parity in prices

• Purchasing power

– Value of money in terms of quantity of

goods it can buy



Implications of PPP

• If purchasing power of the pound

– Is always the same at home and abroad

– Then the real exchange rate cannot change, since

1/P=e/P* or 1=eP/P* so that e=P*/P

• If a Big Mac costs £3 in the UK and $4 in the US

then e=4/3=1.3 dollars per pound

• Theory of purchasing power parity

– Nominal exchange rate between the currencies of

two countries reflects the (overall, aggregate) price

levels in those countries

– So when relative prices change, e must change 36

• We have seen (in lecture 10) that the price

level in any country adjusts to bring the

quantity of money supplied and demanded into

balance

• Because the nominal ER depends on the price

level, it also depends on the money supply and

demand in each country

• So, when a country prints money its exchange

rate should depreciate

– So the depreciation of the £ against the $ that

we saw should reflect higher inflation in the UK

Implications of PPP (cont.)

37

Nominal exchange rate during a hyperinflation

• Natural experiment – hyperinflation

– High inflation

– Arises when a government prints money

to pay for large amounts of government

spending

• German hyperinflation, early 1920s

– Money supply, price level, nominal

exchange rate

• Move closely together




• German hyperinflation, early 1920s

– Money supply - starts growing quickly

• Price level – starts growing

• Depreciation

– Money supply - stabilises

• Price level – stabilises

• Exchange rate – stabilises




• Quantity theory of money

– Explains how the money supply affects

price level

• Purchasing power parity

– Explains how price level affects nominal

exchange rate



Figure 3

41

Money, Prices, and the Nominal Exchange Rate during the

German Hyperinflation This figure shows the

money supply, the price

level, and the exchange

rate (measured as U.S.

cents per mark) for the

German hyperinflation

from January 1921 to

December 1924. Notice

how similarly these

three variables move.

When the quantity of

money started growing

quickly, the price level

followed, and the mark

depreciated relative to

the dollar. When the

German central bank

stabilised the money

supply, the price level

and exchange rate

stabilised as well.

Limitations of PPP

• Theory of purchasing power parity

– Does not always hold in practice, except

perhaps in the long run

– Evidenced by the fact that the real ER is not

constant over time

1. Many goods (e.g. services like haircuts) are

not easily traded

2. Even tradable goods are not always perfect

substitutes

• When they are produced in different countries

• No opportunity for profitable arbitrage

• Transactions costs inhibit profitable arbitrage 42

Limitations of PPP

• Purchasing power parity

– Not a perfect theory of exchange-rate

determination

– Real exchange rates fluctuate over time

• Large & persistent movements in nominal

exchange rates

– Typically reflect changes in price levels at

home and abroad



The Big Mac Index: from

• Fun guide to whether currencies are at their “correct” level

• http://www.economist.com/blogs/dailychart/2011/07/big-mac-index

• In the “long run”, exchange rates should move towards the rate that equalises the prices of Big Macs around the world

• According to purchasing power parity

– Cost of “Big Mac” should be the same in both countries

– Predicted exchange rate = Price in foreign country (in foreign currency) divided by price in U.S.

http://www.economist.com/blogs/dailychart/2011/07/big-mac-index





• At market exchange rates, a burger is 43% cheaper in China than in America

– i.e. the raw Big Mac index suggests that the yuan is 43% undervalued against the dollar

• But cheap burgers in China do not prove that the yuan is undervalued. Average prices should be lower in poor countries than in rich ones because labour costs are lower…

Country

Big Mac Price

Implied PPP rate +

Today's Exchange Rate 1 USD =

Over(+) / Under(-) Valuation against the USD, % ++

in Local Currency

in US dollars

United States $ 4.07 4.0700 --- 1.0000 ---

Argentina Peso 20.0 4.6113 4.92 4.3372 13.4372

Australia A$ 4.56 4.8780 1.12 0.9348 19.8117

Brazil Real 9.50 5.4724 2.34 1.7360 34.7926

Britain £ 2.39 3.7846 0.59 0.6315 -6.5717

Canada C$ 4.73 4.7677 1.16 0.9921 16.9237

Chile Peso 1850 3.8027 455 486.500 -6.4748

China Yuan 14.7 2.3288 3.60 6.3123 -42.9685

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The Macroeconomics of Open Economies: Basic … · The Macroeconomics of Open Economies: Basic Concepts (Chapter 31 in Mankiw and Taylor)